Economic Overview

The United Kingdom is the world's fourth largest economy with GDP valued at over USD$1.4Trl in 2001. The economy is very healthy, with low unemployment, expanding output, and resilient consumption. The strength of consumer consumption has in large part been due to a strong housing market, which is currently 16% above the peak in 1988. The UK has a service-oriented economy, with manufacturing representing an increasingly smaller portion of GDP, equivalent to only one fifth of national output. Their capital market systems are one of the most developed in the world, and as a result finance and banking has become the strongest contributors to GDP. Although the majority of the UK's GDP is from services, it is important to know that they are also one of the largest producers and exporters of natural gas in the EU. The energy production industry accounts for 10% of GDP, one of the highest shares of any industrialized nation. This is particularly important, as increases in energy prices (such as oil), will significantly benefit the large number of UK oil exporters.

Overall, the UK is a net importer of goods with a consistent trade deficit. Its largest trading partner is the EU, with trade between the two constituencies accounting for over 50% of all of the country's import and export activities. The US, on an individual basis, still remains the UK's largest trading partner. The breakdowns of the most important trading partners for the UK are the following:

The central issue that the UK is grappling with is whether or not to join the Euro. The decision on Euro entry has significant ramifications for the UK economy. Currently, this is the key political and economic agenda on the government's plate. The Treasury has specified five economic tests that must be met prior to Euro entry. These tests are:

UK's Five Economic Tests for Euro

1) Is there sustainable convergence in business cycles and economic structures between the UK and other EMU members, so that the UK citizens could live comfortably with euro interest rates on a permanent basis?

2) Is there enough flexibility to cope with economic change?

3) Would joining the EMU create an environment that would encourage firms to invest in the UK?

4) Would joining the EMU have a positive impact on the competitiveness of the UK's financial services industry?

5) Would joining the EMU be good for promoting stability and growth in employment?

The UK is a very political country where government officials are highly concerned with voter approval. If voters do not support Euro entry, the likelihood of EMU entry would decline. The following are some of the arguments for and against adopting the Euro:

Arguments in favor of adopting the Euro:

  Reduced exchange rate uncertainty for UK businesses and lower exchange rate transaction costs or risks

  The prospect of sustained low inflation under the governance of the European Central Bank, should reduce long-term interest rates and stimulate sustained economic growth

  Single currency promotes price transparency

  The integration of national financial markets of the EU will lead to higher efficiency in the allocation of capital in Europe

  The Euro is the second most important reserve currency after the USD

  With the UK joining the Euro, the political clout of the EMU would increase dramatically

Arguments against adopting the Euro:

  Currency unions have collapsed in the past

  Economic or political instabilities of one country would impact the Euro, which would have exchange rate ramifications for otherwise healthy countries

  Strict EMU criteria

  Entry would mean a permanent transfer of domestic monetary authority to the European Central Bank

  Joining a currency union with no monetary flexibility would require the UK to have more flexibility in the labor and housing markets

  There are fears about which countries might dominate the ECB

  Adjusting to new currency will require large transaction costs

One of the primary reasons for not joining the Euro, is that the UK government has sound macroeconomic policies that have worked very well for the country. Their successful monetary and fiscal policies have led them to outperform most major economies in the current economic downturn, including the EU.

Monetary & Fiscal Policy Makers

The Bank of England (BoE) is the United Kingdom's central bank. Monetary policies are centered around achieving an inflation target dictated by the Treasury Chancellor. Currently, this target is RPIX (Retail Price Index) inflation of 2.5%. The central bank has the power to change interest rates to levels that they believe will allow them to meet this target. The MPC holds monthly meetings, which are closely followed for announcements on changes in monetary policy, including changes in the interest rate (bank repo rate).

The MPC publishes statements after every meeting, along with a quarterly Inflation Report detailing the MPC's forecasts for the next two years of growth and inflation and justification for their policy movements. In addition, another publication, the Quarterly Bulletin provides information on past monetary policy movements and analysis of the international economic environment and its impacts on the UK economy. All of these reports contain detailed information on the MPC's policies and biases for future policy movements.

The main policy tools used by the MPC and BoE are:

Bank Repo Rate: This is the key rate used in monetary policy to meet the Treasury's inflation target. This rate is set for the bank's own operations in the market, such as their short term lending activities. Changes to this rate, affect the rates set by the commercial banks for their savers and borrowers. In turn, this rate will affect spending and output in the economy, and eventually costs and prices. An increase in this rate would imply an attempt to curb inflation, while a decrease in this rate would be to stimulate growth and expansion.

Open Market Operations: The goal of open market operations is to implement the changes in the bank repo rate, while assuring adequate liquidity in the market and continued stability in the banking system. This is reflective of the three main objectives of the BoE; maintaining the integrity and value of the currency, maintaining the stability of the financial system, and seeking to ensure the effectiveness of the United Kingdom's financial services. To ensure liquidity, the Bank conducts daily open market operations to buy or sell short term government fixed-income instruments. If this is not sufficient to meet liquidity needs, the Bank would also conduct additional overnight operations.

Important Characteristics of the British Pound

GBP is very liquid

GBP/USD is one of the most liquid currencies in the world, with 6% of all currency trading involving GBP as either the base or counter currency. One of the reasons for the currency's liquidity is the country's highly developed capital markets. Many foreign investors seeking opportunities other than the US have sent their funds to the UK.

GBP carry trades

GBP has one of the highest interest rates among the developed countries. Australia and New Zealand have higher interest rates, but their financial markets are not as developed. As a result, many investors who are currently in or interested in participating in carry trades, will buy GBP.

Interest rate differentials between Gilts and foreign bonds are closely followed

Interest rate differentials between UK Gilts/US Treasuries and UK Gilts/German Bunds are widely watched by FX market participants. These differentials indicate how much premium yield UK fixed income assets are offering over US and European (German Bunds is usually used as a barometer for European yield) fixed income assets, or vice versa. This differential provides traders with indications of potential currency movements, as investors are always looking for assets with the highest yields.

Eurosterling futures can give indications for interest rate movements

Since the UK interest rate or bank repo rate is the primary tool used in monetary policy, it is important to keep abreast of potential changes to the interest rate. Comments from government officials is one way gage biases for potential rate changes, but the BoE is one of the only central banks that require members of the Monetary Policy Committee to publish their voting records. This personal accountability indicates that comments by individual committee members represent their own opinions and not that of the BoE. Therefore, it is necessary to look for other indication of potential BoE rate movements. 3-Month Euro sterling futures reflect market expectations on eurosterling interest rates 3 months into the future. These contracts are also useful in predicting UK interest rate changes, which will ultimately effect the GBP.

Comments on Euro by UK politicians will impact the Euro

Any speeches, remarks (especially from the Prime Minister or Treasury Chancellor) or polls in regards to the Euro will impact the currency markets. Indication for adoption of the Euro tends to put downward pressure on GBP, while further opposition to Euro entry will typically boost the GBP. Reason being that in order for the GBP to come in line with the Euro, interest rates would have to decrease significantly (at the time of this writing, UK interest rates is 4%, versus Euro interest rates of 2.75%). A decrease in the interest rate, would induce carry trade investors to close their positions, or in essence sell GBP. GBP would also decline because of the uncertainties involved with Euro adoption. The UK is performing very well under the direction of its current monetary authority. The EMU is currently encountering many difficulties with member countries breaching EMU criteria. With one monetary authority dictating 12 countries (plus UK would be 13), the EMU has yet to prove that they have developed a monetary policy suitable for all member states.

GBP has positive correlation with energy prices

The UK houses some of the largest energy companies in the world, including British Petroleum. Energy production represents 10% of GDP. As a result, the GBP has a positive correlation with energy prices. Specifically, since many members of the EU import oil from the UK, as oil prices increase, they will have to buy more GBP to fund their energy purchases. In addition, rises in the price of oil will also benefit the earnings of the nations' energy exporters.

GBP crosses - EUR/GBP versus GBP/USD

Although the GBP/USD is more liquid than EUR/GBP, the EUR/GBP is typically the leading gage for GBP strength. The reason is because Britain's primary trade and investment partner is Europe. As a result, moves in the EUR/GBP cross can filter into movements in GBP/USD. Of course, movements in GBP/USD will also affect the EUR/GBP rate. The EUR/GBP rate should be exactly equal to the rate of EUR/USD divided by GBP/USD. Small differences in these rates are often exploited by market participants.

Important Economic Indicators for the UK

  Employment Situation

  Retail Price Index (RPIX)

  Gross Domestic Product (GDP

  Industrial Production

  Purchasing Managers Index (PMI)

  UK Housing Starts